This article is a little dated, but very relevant to investors starting out. All too often I’ll see comments indicating it isn’t good “value” based on some arbitrary P/E. A company can appear to be more “expensive”, but still generate better returns than a similar company that trades at a lower P/E, but has inferior returns on invested capital (ROIC).
Two companies I’ve been looking at are Home Depot ($HD) and Lowe’s ($LOW). Both are excellent companies and both have handily outperformed the market over the last 10 years.
At the start of 2011, both companies were trading at a trailing P/E of approx 18 and both are currently trading at a trailing P/E of approx 22.
A $1000, investment in $LOW would be worth $7668. CAGR of 22.18% (very impressive compared to SPY’s 13.6%)
EPS grew from $1.42 to $7.10 in that period at a CAGR of approx 17.5% (the rest of the returns can be attributed to P/E expansion)
A $1000, investment in $HD would be worth $9267. CAGR of 24.48%
EPS grew from $2.01 to $11.57 in that period at a CAGR of approx 19.13% (the rest of the returns can be attributed to P/E expansion)
The same amount invested in HD resulted in a 20% higher total return over a 10 year period.
I want to be clear that a high ROIC isn’t the be-all and end-all of an investment thesis. The price you pay absolutely matters. But when I screen for stocks, I like to find a company with a solid track record of generating high ROIC over a 10-15 year period. A superior ROIC can be considered a company’s “moat” as it seems to have some secret sauce that lets it generate profits more efficiently than its peers. A healthy ROIC is indicative of a company that is capable of growing the top line efficiently and/or commands strong margins (both of which translate to EPS growth).
Keep in mind, when looking at a company’s ROIC, you want to measure it with respect to their peers and the company’s cost of capital.
I’d say my investment strategy is to find high ROIC businesses in sectors I somewhat understand (consumer staples, consumer goods and retail), build a position when the stock is at a price I find appealing and then hold for as long as the company keeps generating high ROICs (however long that may be). There’s a few variations to the formula that calculates a company’s ROIC, but here’s a simple version that works pretty well (assuming you want to calculate it yourself from the financial statements as opposed to looking it up on Morningstar/ValueLine etc)
ROIC = Operating Profit/(Total Assets – Current portion of Debt – Cash)
So for those of you that may be interested in following that investment strategy, here’s my watchlist (some of which I own).
Consumer Staples – Brown Forman ($BF.A,) Colgate ($CL), Clorox ($CLX), Hershey ($HSY), Coca-Cola ($KO), Altria ($MO), Philip Morris ($PM), Monster Beverage ($MNST), Boston Beer Co ($SAM) and Unilever ($UL).
Consumer Goods – Apple ($AAPL), Lululemon Athletica ($LULU) and Nike ($NKE).
Retail and Restaurants – Dominos ($DPZ), Home Depot ($HD), McDonalds ($MCD), O’Reilly Auto Parts (ORLY) and Starbucks ($SBUX), Ross Stores ($ROST) and TJX Companies ($TJX).
Financial Services – Mastercard ($MA) and S&P Global Inc ($SPGI)
There’s no guarantee that such stocks will always outperform or that they can maintain high ROICs indefinitely. However, it’s a good place to start.
TLDR: High ROIC companies generally trade at a premium. This is because they are able to grow earnings faster and/or return more capital to shareholders in the form of dividends and buybacks.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.